E-commerce giant Amazon (AMZN 0.48%) launched the now-ubiquitous Amazon Web Services way back in 2006. It took a while for the concept of cloud computing to really catch on, but today, AWS is churning out over $20 billion of revenue each quarter.

And unlike Amazon's core e-commerce business, AWS sports sky-high profit margins. In the third quarter of 2022, AWS reported an operating margin of 26%.

Growth has been relentless for AWS and the cloud infrastructure market over the past decade. Start-ups are choosing cloud computing by default, and enterprises are increasingly moving workloads to the cloud. AWS has snagged around 34% of the market, becoming the default cloud provider for many businesses. In the long run, it seems likely that demand will continue to grow at a healthy pace.

However, AWS may now be facing the first substantial headwind since it emerged as the key profit engine for Amazon.

Canary in the coal mine

Amazon's management has already indicated that AWS customers had started to care a lot more about their cloud computing bills amid a tough economic climate. CFO Brian Olsavsky said during the third-quarter earnings call back in October: "...when I talk about enterprise customers in AWS, yes, we've been working with customers to lower their bills. We do see some of the consumers are cutting their budgets and trying to save money in the short run."

Amazon reported 27% year-over-year revenue growth for AWS in the third quarter, but Olsavsky said that growth had slowed to a mid-20% rate by the end of the quarter. For Amazon's fourth-quarter guidance, the company assumed this mid-20% growth rate would continue.

Amazon's warning about AWS customer behavior was the first indication that growth for the all-important cloud business was slowing. The latest earnings report from memory chip manufacturer Micron (MU -3.52%) provides further evidence that a downturn for the cloud infrastructure industry is well on its way.

Micron manufactures DRAM and NAND memory chips. Although the company doesn't break out sales to data center customers, Micron is seeing those customers pull back. "In data center, we expect cloud demand for memory in 2023 to grow well below the historical trend due to the significant impact of inventory reductions at key customers," said CEO Sanjay Mehrotra in the latest earnings call.

One of those mentioned key customers is almost certainly AWS, given its size. Cloud infrastructure providers built up inventories of memory chips based on growth expectations that turned out to be overly optimistic, and now they're slowing down expansion to account for weakening demand growth. Micron believes this will be an issue throughout 2023.

AWS profits could take a hit

Amazon's cloud business is about as capital intensive as it gets, and profitability all comes down to utilization. All the servers, chips, and networking gear that fill Amazon's data centers incur depreciation expenses regardless of whether they're being fully used. Those fixed costs are there no matter how much revenue is generated.

During times when Amazon can accurately predict future demand, it can tailor the expansion of its infrastructure to match that demand and keep utilization rates high. But if the company overestimates future demand and builds excess capacity, utilization rates can drop.

Based on what Amazon has said about customers slowing down spending and what Micron has said about depressed sales of memory chips to cloud providers throughout 2023, it seems likely that Amazon has overbuilt its cloud business to a degree. Operating margin for AWS was down about 4 percentage points year over year in the third quarter, which suggests that the company expanded too quickly.

When Amazon reports its fourth-quarter results in a month or so, investors should brace themselves for deteriorating AWS profitability. At a time when the retail side of the business is producing giant losses, disappointing results from AWS aren't going to help the stock recover.